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Do Inventory Turnover rates Matter?

Updated: May 11, 2020

Turn-rates are essential to gain financial sustainability as it often signifies if the rubber is meeting the road. Many concerns are critical to purchasing inventory supported by a pull-environment focused on demand. To explain a pull system, often the actual demand drives stock while being pulled from the producer to ensure inventory levels.

The inventory turnover correlates to the amount of purchased inventory (the investment) relevant to the number of sales (Return on Investment) over a specific time. Many companies may audit their churn rates quarterly and some yearly. The ratio between sales in comparison to the held inventory is the fundamental calculation that defines the cost-of-inventory (cost of investment).

A few calculations for inventory

  1. The calculation for inventory consumption includes Inventory Usage (IU) derived by the Starting Inventory (SI) plus Received Products Order (RP) subtracting Ending Inventory (EI).

  2. The calculation for turn rates incorporates cost-of-goods sold for the period is $100,000, and the average inventory is $25,000, then 100,000 is divided by $25,000 for an inventory turnover rate of 2.5.

  3. Others may use "market value of sales" divided by "ending inventory" or COGS divided by "average inventory".

The typical inventory turnover ratio is approximately 4 to 6. Although businesses are distinctively different and, in general terms, will present a distinct ratio signifying a rate at which restocking items are well balanced collectively with sales.

To explain using units; If you sold 1,000 units in a single year, and had 1,000 units in stock on average, then you have achieved a 1:1 ratio and typically declared as 1 for a ratio. You can say the inventory turned over once in a single year. Many have achieved this outcome because of weak sales and excessive inventory levels (bad investment?). The implication is a reliable indication concerning stock-flow during the year while analyzing throughput.

The outcome triggers the conclusion of poor forecasting leading to over purchasing without evaluating sell trends. The result causes a push environment driven by discounting the product while sacrificing margins. Other evaluations may reference the vendor or the lack of competition in your vendor pool. If you only have one vendor, you have "no" leverage appropriate to shopping fair wholesale rates to sustain required margins or maintaining a good investment. If this is the case, the vendor or supplier holds the leverage while dictating prices, lowering quality, and reducing availability.

In some cases, I have found low turn-rates to be the result of high pricing, influenced by high wholesale rates without exploring other accessible vendors. The objective is to shop rates, quality, quantity, and dependability while leveraging the vendor pool to negotiate the unit price that affects margins. It becomes challenging to achieve sales goals if pricing is too high, causing customers to leave to fulfill their needs elsewhere.

Another example is using Walmart, they reported in their fiscal year 2019, sales reached $514 Billion as year-end inventory was $44 Billion, and an annual COGS (cost of goods sold) or cost of sales of $385 Billion.

The results signifying inventory turnover is as follows

$385 Billion divided by $44 Billion equals 8.7

its day's inventory equal

(1 / 8.7) * 365 = 42 days

The above results illustrate the ability to sell out of inventory in 42-days - very impressive!

If you experience a high inventory turn rate, the outcome suggests strong sales, strategic forecasting, and mindful of restocking to create a sales balance. The result may indicate low pricing driven by excellent performance. However, when supply exceeds demand, and turn rate is rapid, this may signify an opportunity to raise prices to increase the return on investment.

These calculated ratios enable industry comparisons to measure success or shortfalls while reviewing key performance indicators (KPI's) relevant to average revenue per unit, customer lifetime value, and sales growth. I

Does inventory turn matter?

Excess inventory has a significantly high cost when configuring operations relevant to financing the purchase to hold in stock while unable to spend money on labor to manage the process. There are many reasons why turn ratios are essential.

  1. The results will quickly inform the business of same-store sales, sales per square foot relevant to maximizing floor space.

  2. The effects will enable valid comparisons to industry standards.

  3. Enables the ability to measure sales volumes collectively with performance against a broader market.

  4. The process enables the critical measurement where the rubber hits the road appropriate to the product performance.

  5. It provides the business with a clear and valuable insight applicable to managing inventory, sales, and cost.

Although I provided many reasons for the importance of turn ratios, it also matters with e-commerce when providing a vital measurement related to both business and product performance. eCommerce is capable of measuring traffic with the utilization of analytics; they may not sincerely know details of their sales, inventory, and costs without comprehending their inventory turnover ratio.

When operating in a brick-and-mortar, the business can monitor customer traffic, and the number of customers successfully served in comparisons to the health of the cash register at the end of the day.

Let us face it, inventory "matters" to ensure the business is effectively measuring inventory turn rates to signify sales while managing their supply chain. Sales goals are required to align with product performance essential to customer demand while maintaining profit margins. The ratio illustrates the performance of managing inventory (company investment) relevant to purchasing too much or too little.

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